Chapter 9the Cost Of Capital 2017 Pearson Education Inc All Rights ✓ Solved

Chapter 9 The Cost of Capital © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Learning Objectives Understand the concepts underlying the firm’s cost of capital. Evaluate the costs of the individual sources of capital Calculate a firm’s weighted average cost of capital. Estimate divisional costs of capital. © 2017 Pearson Education, Inc.

All rights reserved. 9-‹#› THE COST OF CAPITAL: KEY DEFINITIONS AND CONCEPTS © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Capital Capital Capital represents the funds used to finance a firm's assets and operations. Capital constitutes all items on the right hand side of balance sheet, i.e., liabilities and common equity.

Main sources: Debt, Preferred stock, Retained earnings and Common Stock © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Opportunity Cost of Capital Cost of Capital The firm’s cost of capital is also referred to as the firm’s opportunity cost of capital. © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Investor’s Required Rate of Return Investor’s Required Rate of Return – the minimum rate of return necessary to attract an investor to purchase or hold a security.

Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs. Impact of taxes: For example, a firm may pay 8% interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%. © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Investor’s Required Rate of Return Impact of transaction costs on cost of capital: For example, If a firm sells new stock for .00 a share and incurs in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital? The firm has only .00 to invest after transaction cost.

0.15 à— .00 = .5 k = .5/(.00) = 0.1667 or 16.67% (rather than 15%) © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› Financial Policy A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used. For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix will impact the cost of capital. © 2017 Pearson Education, Inc.

All rights reserved. 9-‹#› DETERMINING THE COSTS OF THE INDIVIDUAL SOURCES OF CAPITAL © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Cost of Debt The bondholder’s required rate of return on debt is the return that bondholders demand. As seen in Chapter 7, this can be estimated using the bond price equation: © 2017 Pearson Education, Inc.

All rights reserved. 9-‹#› The Cost of Debt Since firms must pay flotation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation: © 2017 Pearson Education, Inc. All rights reserved.

9-‹#› () - text needs to be changed to "kB" to reflect most recent equation -Stephanie Lindsey The Cost of Debt See Example 9.1 Investor’s required rate of return on a 8% 20-year bond trading for 8.32= 9% After-tax cost of debt = Cost of debt*(1-tax rate) At 34% tax bracket = 9*(1 – 0.34) = 5.94% © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Cost of Preferred Stock If flotation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm. Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for flotation cost to give us the net proceeds. Net proceeds = issue price – flotation cost © 2017 Pearson Education, Inc.

All rights reserved. 9-‹#› The Cost of Preferred Stock Cost of Preferred Stock: Pn = net proceeds (i.e., Issue price – flotation costs) Dp = preferred stock dividend per share Example: Determine the cost for a preferred stock that pays annual dividend of .25, has current stock price .50, and incurs flotation costs of .375 per share. Cost = .25/(58.50 – 1.375) = 0.074 or 7.44% © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Cost of Common Equity Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend.

Furthermore, the costs will vary for two sources of equity (i.e., retained earnings and new issue). © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Cost of Common Equity There are no flotation costs on retained earnings but the firm incurs costs when it sells new common stock. Note that retained earnings are not a free source of capital. There is an opportunity cost. © 2017 Pearson Education, Inc.

All rights reserved. 9-‹#› Cost Estimation Techniques Two commonly used methods for estimating common stockholder’s required rate of return are: The Dividend Growth Model The Capital Asset Pricing Model © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Dividend Growth Model Investors’ required rate of return (For Retained Earnings): D1 = Dividends expected one year hence Pcs = Price of common stock g = growth rate © 2017 Pearson Education, Inc. All rights reserved.

9-‹#› The Dividend Growth Model Investors’ required rate of return (For new issues) D1 = Dividends expected one year hence Pcs = Net proceeds per share g = growth rate © 2017 Pearson Education, Inc. All rights reserved. 9-‹#› The Dividend Growth Model Example: A company expects dividends this year to be .10, based upon the fact that were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at a share.

Cost of retained earnings: Kcs = (D1/Pcs) + g 1.1/35 + 0.10 = 0.1314 or 13.14% Cost of new stock (with a